Why you need human capital due diligence
Do your ‘assets’ walk out the door or log off at the end of the day? Does your business success rest on creating and preserving customer loyalty and consumer trust? Is the value of your business – or a business you’d like to invest in or acquire, built on innovation, creativity, relationships, safety, quality service, caring, compassion, attention to detail? If so, it will come as little surprise to you that “[b]etween 1995 and 2015, the share of intangible asset market value (IAMV) increased from 60% to 84%. … COVID-19 has accelerated the trend of increasing IAMV share, with intangible assets now commanding 90% of the S&P market value,” says Ocean Tomo’s Intangible Asset Market Value Study (2020).
How are intangible assets accounted for in your buy- or sell-side activities, do you conduct diligence on them? Due diligence can be defined as the comprehensive appraisal of a business conducted by a potential buyer or investor, especially to understand the business’s assets and liabilities and evaluate its commercial potential. You are likely very familiar with traditional due diligence activities such as quality of earnings (QofE), tax, and legal. More investors and acquirers are conducting commercial, operations, technology, even distribution and supply chain diligence.
In fact, the human experience of business is of such concern that the European Commission recently proposed legislation that would require organizations of 500 employees or more with annual revenue over 150 million euros (approx $170 USD) to conduct due diligence in supply chains to detect, prevent and mitigate human rights violations (e.g. child labor, environmental hazards, etc.).
You may already look at total cost of workforce, pension and benefits, pending employment litigation and executive leadership talent, each uniquely important. However, this is not a comprehensive view of the risks and value creation opportunities tied to your most significant line item – human capital., the assets who lock-up and log-out each day.
Human capital due diligence, done right, offers insight into risks and liabilities tied to human resources practices, payroll and timekeeping processes, compliance with statutory federal, state and local employment guidelines, alignment and disconnects in policies and practices as you seek to integrate organizations. When tied to an investment thesis or strategic acquisition plan, human capital diligence can identify blind-spots, derailers and undiscovered opportunities in the deal.
Not long ago, we worked with a private equity firm on the platform acquisition of a small, extremely profitable healthcare technology firm. The market was penetrated at less than 8% and the deal thesis included a significant investment in sales and business development support to tap all of the available opportunities. Part of the diligence processes included interviews with the employees to understand their experience of the organization, its leadership, and opportunities for improved performance and business growth. We learned that there was already a significant backlog in client deliverables with no existing plan to invest in or partner for increased capacity to meet current customer demand.
Adding sales and business development support without expanding the delivery team would have blown up this business. Brand reputation would have eroded, employees would have folded under the weight of an already overwhelming pipeline of business opportunities, and sales talent would have been frustrated at the inability to sell products and services that could not be delivered. We immediately surfaced our findings and worked with the financial sponsors to revise the 12-month plan.
Approximately 85% of the deals we touch surface at least one Fair Labor Standards Act (FLSA) employee classification concern. These result from poor job documentation, confusion about the regulations, inconsistent or inappropriate employee timekeeping practices or payroll processes. Left unchecked, job classification issues can result in employee relations concerns, lawsuits and compliance penalties. We’ve even seen portfolio companies carry these practices through the hold-and-grow cycle and then have difficulty exiting because of the expanded liability.
Comprehensive human capital due diligence should look at these and a whole host of other items. It is not unusual for such a process to look at more than 175 discrete items, not including aspects of leadership, culture, and direct employee experience.
Human Capital Due Diligence Checklist
A human capital due diligence checklist can help you in evaluating your current process. In addition to identifying areas of opportunity and concern, the human capital diligence (or human resources due diligence) process should also provide a roadmap for remediation and value creation. Your diligence provider should be able to seamlessly plug in to your project management office (PMO) or deal team. A comprehensive, coordinated effort will make for a much stronger investment in the long run.
We have provided a truncated sample version of our own human capital due diligence checklist below. If you have any questions or comments, please drop us a line at the 29Bison Contact Us page.